Fixed Costs

Learning Outcomes

  • Understand the effects of sale mix on fixed costs

Here again, are five basic questions to address as you contemplate segments with regard to the sales mix:

  1. Does the segment have a positive contribution margin?
  2. What happens to fixed costs if we eliminate a segment?
  3. How will dropping a product or segment affect other areas of the business?
  4. What can the company do with freed-up capacity?
  5. What are the qualitative (non-financial) considerations?

We looked at what would happen to the company if it dropped the HighLine model, but we did not take into account what might happen with fixed costs.

Question 2: What happens to fixed costs if we eliminate a segment?

We have this information with regard to fixed costs per month:

Description Total
Sales Salary $  10,000
Selling, General, and Administrative 90,000
Production Facility Rent 10,000
Single Line$ 110,000Double line

 

Let’s say we decide to allocate sales salary and SG&A based on the number of units of each model sold, and production facility rent based on the number of square feet each model occupies. You have this information:

Production facility usage MidLine HighLine LowLine Total
Square feet       5,000       4,000       1,000       10,000
Allocation rate 50.00% 40.00% 10.00% 100.00%

 

The Midline production operation takes up half of the available space in the production facility, so we allocate half of the rent to that segment, and 4,000/10,000 of the rent to HighLine, and so on.

For rent and sales salaries, we have decided to allocate costs based on units sold. We would choose whatever base made the most sense for a particular business—and that was cost-effective to collect the data on. In this case, we can get the units sold very easily, and we can make a logical argument that fixed costs could be allocated on that basis.

Sales Salaries and SG&A MidLine HighLine LowLine Total
Unit sold             60             10             20               90
Allocation rate 66.67% 11.11% 22.22% 100.00%

 

Allocating based on these assumptions, and rounding to the nearest whole dollar, we get the following:

Fixed costs per month MidLine HighLine LowLine Total
Sales Salary $  6,667 $  1,111 $  2,222 $  10,000
Selling, General, and Administrative 60,000 10,000 20,000 90,000
Production Facility Rent 5,000 4,000 1,000 10,000
Single Line$ 71,667Double line Single Line$ 15,111Double line Single Line$ 23,222Double line Single Line$ 110,000Double line

 

This then gives us this revised CVP analysis:

3Yachts, Inc.
Product Mix
CVP Analysis (month)
MidLine HighLine LowLine Total
Subcategory, Assumptions
Sales price per unit $6,500 $11,000 $4,000
Variable cost per unit $4,695 $12,050 $3,180
CM per unit Single Line$1,805Double line Single Line($1,050)Double line Single Line$820Double line
Fixed costs per month $71,667 $15,111 $23,222 $110,000
Sales volume 60 10 20
Subcategory, CVP Model Results MidLine HighLine LowLine Total
Sales $  390,000 $  110,000 $   80,000 $  580,000
Variable costs 281,700 120,500 63,600 465,800
Contribution margin Single Line108,300 Single Line(10,500) Single Line16,400 Single Line114,200
Fixed costs 71,667 15,111 23,222 110,000
Operating income Single Line$   36,633Double line Single Line$ (25,611)Double line Single Line$  (6,822)Double line Single Line$    4,200Double line

 

Notice that when we allocate fixed costs, although the LowLine shows a positive contribution margin, it shows an operating loss. Total contribution margin based on sales of 20 units per month does not cover that model’s allocated fixed costs.

Let’s see what happens if we eliminate the HighLine and fixed costs do not change:

We have to reallocate rent on the production facility. For purposes of this analysis, let’s assume the 4,000 square feet HighLine production space either remains vacant or the MidLine and LowLine production lines spread a bit and take up that space. In either case, we have to reassess the amount of rent we will allocate to each segment, assuming the rent can’t go down just because we aren’t using that space:

Production facility usage MidLine HighLine LowLine Total
Square feet       8,000               –       2,000     10,000
Allocation rate 80.00% 0.00% 20.00% 100.00%

 

Let’s also, for now, assume that SG&A and sales salaries remain the same but are now allocated over fewer units:

Sales Salaries and SG&A MidLine HighLine LowLine Total
Unit sold             60               –             20             80
Allocation rate 75.00% 0.00% 25.00% 100.00%

 

Fixed costs allocated over two segments instead of three look like this:

Fixed costs per month MidLine HighLine LowLine Total
Sales Salary $7,500 $2,500 $10,000
Selling, General, and Administrative 67,500 22,500 90,000
Production Facility Rent 8,000 2,000 10,000
Single Line$83,000Double line Single LineDouble line Single Line$27,000Double line Single Line$110,000Double line

 

Notice that total fixed costs remain the same in this analysis, as does the bottom line, but the LowLine model fares even worse:

3Yachts, Inc.
Product Mix
CVP Analysis (month)
MidLine HighLine LowLine Total
Subcategory, Assumptions
Sales price per unit $6,500 $11,000 $4,000
Variable cost per unit $4,695 $12,050 $3,180
CM per unit Single Line$1,805Double line Single Line($1,050)Double line Single Line$820Double line
Fixed costs per month $83,000 $0 $27,000 $110,000
Sales volume 60 20
Subcategory, CVP Model Results MidLine HighLine LowLine Total
Sales $  390,000 $   80,000 $  470,000
Variable costs 281,700 63,600 345,300
Contribution margin Single Line108,300 Single Line Single Line16,400 Single Line124,700
Fixed costs 83,000 27,000 110,000
Operating income Single Line$   25,300Double line Single LineDouble line Single Line$  (10,600)Double line Single Line$    14,700Double line

 

Now let’s re-run this analysis with the assumption that by eliminating the HighLine model, which was sales-intensive, we could lay off one of the two salespeople, saving the company $5,000 per month, and cut SG&A by $10,000. Our fixed costs now look like this:

Fixed costs per month MidLine HighLine LowLine Total
Sales Salary $   3,750 $   1,250 $   5,000
Selling, General, and Administrative 60,000 20,000 80,000
Production Facility Rent 8,000 2,000 10,000
Single Line$ 71,750Double line Single LineDouble line Single Line$ 23,250Double line Single Line$ 95,000Double line

 

And our CVP analysis looks like this:

3Yachts, Inc.
Product Mix
CVP Analysis (month)
MidLine HighLine LowLine Total
Subcategory, Assumptions
Sales price per unit $6,500 $11,000 $4,000
Variable cost per unit $4,695 $12,050 $3,180
CM per unit Single Line$1,805Double line Single Line($1,050)Double line Single Line$820Double line
Fixed costs per month $71,750 $0 $23,250 $95,000
Sales volume 60 20
Subcategory, CVP Model Results MidLine HighLine LowLine Total
Sales $  390,000 $0 $   80,000 $  470,000
Variable costs 281,700 $0 63,600 345,300
Contribution margin Single Line108,300 Single Line$0 Single Line16,400 Single Line124,700
Fixed costs 71,750 $0 23,250 95,000
Operating income Single Line$   36,550Double line Single Line$0Double line Single Line$  (6,850)Double line Single Line$   29,700Double line

 

Let’s look at this using differential analysis:

Description Amount Total
Expected decrease in revenue ($110,000)
Expected decrease in total variable costs $120,500
Expected decrease in fixed costs $15,000
Expected decrease in total costs Single Line $135,500
Expected increase/(decrease) in operating income Single Line$25,500Double line
Current operating income $4,200
Expected increase/(decrease) in operating income $25,500
Projected operating income Single Line$29,700Double line

 

Eliminating the HighLine and cutting costs increase the bottom line by $25,500 per month. That’s $306,000 per year.

However, we still have three questions left to answer.

Before we address those last three considerations, check your understanding of how changing the product mix affects fixed costs.

Practice Question